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					                                                                           The Economics of Health Care

                                                     CHAPTER THIRTY-SIX
                                           THE ECONOMICS OF HEALTH CARE

This chapter addresses one of the most prominent economic and political issues of our time. Providing
health care is an economic issue, and the American public‘s concern ranges from the problem of rising
health care costs, to gaps in health insurance coverage, to government insurance programs draining
Federal and state budgets. The debate over the desirability of more government involvement in
providing health insurance continues.
Chapter 36 examines the economic aspects of our health care problems, offers a demand and supply
analysis to explain rapid increases in health care costs, and evaluates some methods of containing
increases in health care costs.

The structure and central topics of the chapter have not changed, but there are a number of revisions.
Most of them involve updating data or expanding discussions based on changes in institutions, laws, or
medical knowledge. The Health Care Financing Administration is now the Centers for Medicare and
Medicaid Services. Discussions of the value added from improved longevity, the effect of overeating and
inactivity on illness, prescription drugs as improvements in medical technology, and a number of policy
changes have been added.

A “Consider This” box has been added that provides an example of how technological changes
contribute to rising health care costs.

There is a new end-of-chapter question, the “Last Word” question is now a web-based question, and the
web-based question on AARP has been replaced with one on health expenditures per capita.

After completing this chapter, students should be able to

  1. Describe what is meant by the health care industry and approximate its size with relevant data.
  2. Identify the problem connected with rising health care costs.
  3. Give the negative effects associated with rising health care costs.
  4. Explain what is meant by the overallocation of resources to the health care industry.
  5. Describe the extent of the problem regarding a lack of health insurance coverage.
  6. Identify four special characteristics of the health care market.
  7. Give four factors that have contributed to the rise in the demand for health care.
  8. Explain the role of physicians in increasing the demand for health care.
  9. Explain the “moral hazard” problem arising from health insurance coverage.
10. Explain how the Federal income tax structure subsidizes health care demand.
11. Identify three supply factors that contribute to rising health care costs.
12. Identify three basic reform proposals designed to increase access to health care.

The Economics of Health Care

13. Explain what National Health Insurance is.
14. Present the arguments for and against National Health Insurance.
15. Explain how insurance company deductibles, co-payments, and preferred provider organizations
    might help contain health care costs.
16. Outline the recent laws passed by Congress and some of proposals before Congress.
17. Define and identify terms and concepts listed at the end of the chapter.

 1. There is a wealth of information available on health care in the popular press. This topic provides
    an excellent opportunity for student debates, papers, and presentations. Because it is an issue that
    concerns so many of us, you can easily get students to relate their personal experiences to the
    economics of health care. Once you have their interest, you can relate their concerns to many of
    the theoretical and structural concepts raised in microeconomics. The material can also be used to
    help students better appreciate the macroeconomic tradeoffs, especially as they pertain to health
    care reform proposals.
 2. The National Issues Forum has some excellent teaching materials that provide a focus for
    discussing some of the major issues. Related to this chapter are two of their topics, “The Health
    Care Cost Explosion: Why It’s So Serious, What Should Be Done, “ and “Health Care for the
    Elderly: Moral Dilemma, Mortal Choices.” This organization also has units that focus on
    “Coping with AIDS” and “The Drug Crisis,” which may be useful supplements in a more
    interdisciplinary course. For more information about their issue books, audiocassette tapes, and
    videocassettes, call 1-800-433-7834 or write to them at 100 Commons Road, Dayton, Ohio
 3. The Nebraska Council on Economic Education has an excellent set of activities, suitable for
    secondary or college-level classes, which revolve around the economics of health care and are
    available for about $10. They also have a video, “Code Blue,” of a teleconference panel
    highlighting some of the major issues. For more information call 1-800-328-2854 or
    402-472-2333 or FAX 402-472-9700.
 4. The health care industry can be analyzed from the perspective of market structure, which
    reinforces what students have just learned about the different market models, from perfect
    competition to pure monopoly. How do the markets for various types of health care services fit the
    various market models? If the market being examined does not fit the competitive model, or if
    consumers pay indirectly through prepaid insurance plans, does it make sense to talk about market
    solutions? If market solutions are possible, should reforms be aimed at enhancing competition?
    The health care industry, or particular components of it, provide excellent opportunities for using
    the case-study method to teach economic concepts.
 5. Price elasticity and income elasticity of demand both play an important role in the problems of the
    health care industry. Most health care services are a necessity with few substitutes, making the
    demand for them relatively price-inelastic. This fact means that rising costs of production that
    decrease supply will have more impact on the price of health care than on the quantity purchased.
    Health care is a normal good, meaning that as incomes rise the demand for health care will also
    increase. Employing this chapter as a demonstration when studying the theory of elasticity in
    Chapter 20 can be an effective combination.
 6. The discussion of health care can lead easily to the discussion of how we value human life. A fun
    and illuminating exercise is to place students on “organ donation” boards, where they (in small
    groups) must decide which candidate receives a vital organ (the nonrecipients die). Write profiles
    for four or five prospective recipients, assume that all have the same level of compatibility with the

                                                                          The Economics of Health Care

       donor’s organ, and include information such as age, reason for organ need (genetics, unhealthy
       lifestyle, accident, etc.), annual income (or prospective annual income for students), and family
       situation (single, married, children, etc.). These are of course hypothetical, but for an added bit a
       fun write profiles of what would happen to each candidate if he or she received the organ (brilliant
       student flunks out, welfare recipient goes on to win Nobel Prize, and so on).

Do not assume your younger students know anything about health insurance coverage, even at the
personal level. Unless they have encountered some problem, it is probably one of those economic costs
that they have ignored, since they are covered by their parents’ insurance or the university health center.
The students who have encountered some problem with coverage will help you “open other students’

I.      Introduction
        A. The high costs of health care in the United States are frequently the subject of news reports.
            1. People without health insurance.
            2. Federal and state budgets strained by health care costs.
            3. Labor dispute over health insurance.
            4. Insurance companies dictating the medical care doctors can provide.
            5. Ethical questions concerning the acutely or terminally ill.
        B. This chapter focuses on several issues.
            1. The United States system of health care.
            2. The economics of health care costs.
            3. Actual and proposed reforms.
II.     The Health Care Industry
        A. Government’s definition of this far-reaching industry includes many aspects.
            1. Services provided in hospitals, nursing homes, labs, physicians’ and dentists’ offices.
            2. Prescription and nonprescription drugs, artificial limbs, and eyeglasses.
            3. Services of many nontraditional practitioners, but not fitness club services, or health
        B. The size of the industry is immense.
            1. Nine million are employed in the industry, including 700,000 physicians.
            2. There are about 5,800 hospitals with almost 1 million beds.
            3. Health care accounts for more than 14 percent of GDP.
III.    Twin problems: cost and access
        A. Health care costs include the “price” of health care as well as the “quantity” of health care
           services provided.

The Economics of Health Care

      B. Health care costs have been rising rapidly because of higher prices and an increase in the
         quantity of services provided. The price of medical care has been increasing far faster than
         the overall price level.
      C. Efforts to reform health care have focused on controlling costs and increasing accessibility.
         A dual system of health care (one for those who can afford to pay and the other for those
         who cannot) may be evolving.
IV.   High and rising health care costs.
      A. Health care spending in the U.S. is rising in absolute terms, as a percentage of domestic
         output, and on a per capita basis.
      B. Figure 36-1 shows major types of spending and major sources of funds for these
          1. Thirty-three cents of each health care dollar is spent on hospitals; 22 cents goes to
             physicians; 22 cents goes to dental and vision care; and 23 cents pays for other health
             care services, including prescription drugs, home care, and program administration.
          2. About 80 percent of expenditures are paid for by public and private insurance; the
             remaining amount is paid by the health-care consumer.
      C. Health care absorbed 5.1 percent of GDP in 1960, 14.1 percent in 2001, and is projected to
         increase to 16.4 percent by 2008. (See Figure 36-2.)
      D. Global Perspective 36-1 shows that per capita spending on health care is higher in the U.S.
         than in any other major industrialized nation.
      E. Quality of care: Are we healthier?
          1. Medical care in the U.S. is probably the best in the world, but not our health.
          2. As a result of medical research, the incidence of certain diseases has been declining and
             the quality of treatment has been improving in the U.S. But the U.S. has a lower life
             expectancy, higher maternal mortality and infant mortality rates, an AIDS epidemic that
             has claimed over 486,000 lives, and an increase in tuberculosis.
          3. The U.S. Office of Technology Assessment has concluded that the U.S. ranks low
             internationally on may health indicators.
      F. There are economic implications of rising costs.
          1. The increase in health care costs is the main reason for rising health care spending.
          2. Increased health care costs have other effects as well.
              a. Fewer uninsured workers can afford health care; fewer employers can offer health
                 insurance to workers.
              b. Adverse effects on labor markets exist.
                  i.   Wages grow more slowly because health care benefits are taking a larger share
                       of the “compensation” package.
                  ii. Employers use more part-time and temporary workers to avoid the high cost of
                      health insurance coverage for workers. Employer may contract-out the work of
                      low-paid workers to avoid paying health care costs.
              c. Government budgets at all levels have to deal with spiraling health care

                                                                      The Economics of Health Care

                  i.   Medicare and Medicaid has been the fastest growing segment of the Federal
                  ii. Higher taxes or reductions in other budget components (national defense,
                      education, environmental programs) must be used to cover the increases.
                  iii. States are finding it difficult to cover their share of Medicaid costs and must
                       reduce other expenditures (infrastructure, education, and welfare).
                  iv. Local governments face similar strains.
      G. A basic allocation problem.
         1. Most industries are happy to have increased spending. Why are we alarmed about more
            spending on health care? According to economist William Nordhaus, the economic
            value of increased longevity is roughly equal to the increased GDP over the last 100
            years. Despite this, economists see health care expenditures as inefficiently large, a
            product of the unique features of the health care market.
         2. Experts are concerned that at the margin, the consumption of health care is worth less
            than the alternative goods and services that could otherwise have been produced with
            those resources. In other words, there is an overallocation of resources to health care,
            which imposes a real economic cost on society.
V.    Limited access: Many are uninsured.
         1. In 2001 about 41 million Americans (15 percent of population) had no health insurance
            for the entire year. About 75 million people were uninsured at some point in 2001 or
            2002. This number grows as health care costs rise.
         2. Which groups have no insurance?
             a. Fifty percent of the uninsured are families where the head works full time, the family
                income is too high to qualify for Medicaid, but the earned income is not enough to
                afford health insurance. Many are single-parent families, African American, or
             b. Young people with excellent health choose not to buy health insurance.
             c. The chronically ill find it impossible or too costly to obtain insurance because of the
                likelihood they will incur substantial costs in the future.
             d. The unemployed lack insurance because most policies accompany employment.
             e. Workers for small firms are unlikely to have insurance because high administrative
                costs make it costly for small business employers to offer this benefit.
             f.   Part-time and low-wage workers are also less likely to be insured.
         3. The uninsured will sometimes pay directly, but often wait until their illness is so critical
            that the hospital emergency room is the only alternative, and this adds to hospitals’
            uncompensated health care burdens, estimated at $20-25 billion per year. Hospitals are
            forced to shift these costs to other health-care customers.
VI.   Why the rapid rise in costs?
      A. The health care market is unique.
         1. Ethical and equity considerations are intertwined. Society regards much of health care as
            a right and is reluctant to ration it solely on the basis of who can afford it.

The Economics of Health Care

          2. Information is asymmetric: Physicians and other caregivers possess more information
             about the product than the consumer. Often the provider orders the service for the
             consumer or patient.
          3. Spillover or external benefits exist. Healthy individuals make the entire society more
             productive and contribute to general prosperity and well-being.
          4. Third-party payment or payment by the insurance company means that the consumer has
             little or no direct out-of-pocket expenditure for health care services. Therefore, the
             consumer does not seek out the lowest cost alternative.
      B. The demand for health care has been increasing.
          1. Health care is a “normal” good, so when incomes rise, the demand for health care rises
             proportionately. Elasticity with respect to income is estimated to be about 1 and may be
             as high as 1.5 in the U.S.
          2. Demand for most health care is believed to be price “inelastic,” which means that the
             quantity demanded does not decline with rising prices.
              a. Most health care is a necessity.
              b. There are few substitutes for most health care services.
              c. Consumers do not “shop around” for doctors in most cases.
              d. Patients with insurance do not care much about the price of each service received
                 since they prepay for the total package.
          3. The population is aging. By 2000 the proportion those over age 65 had risen to 12.4
             percent from 9 percent thirty years earlier. Those over 65 consume 3 1/2 times more
             health care services as those between 19 and 64. By 2030 the proportion of the
             population over age 65 will be almost 20 percent.
          4. Unhealthy lifestyles, particularly substance abuse, are common, although smoking is
          5. The role of physicians may increase the demand for health care.
              a. Supplier-induced demand. Asymmetric information exists, meaning that doctors
                 possess more information about health care needs than do their patients (consumers)
                 and doctors order the services for them. Also doctors are paid on a “fee-for-service”
                 basis, which encourages them to order more services, and patients seldom have
                 advance information on the cost or necessity of these services.
              b. Defensive medicine is common in that doctors err on the side of being overly
                 cautious to avoid any charges of malpractice. They often order many procedures that
                 may not be necessary.
              c. Medical ethics cause doctors to use the “best practice” to serve their patients and to
                 try to sustain human life regardless of cost.
          6. Insurance pays about 78 percent of health care costs. While this is positive in providing
             security against devastating losses, it creates a “moral hazard” problem.
              a. Insured may seek more health care and engage in more damaging behavior than the
              b. Overconsumption occurs because people regard health care as “free,” since they
                 have prepaid for their services.

                                                                       The Economics of Health Care

             c. Price provides a direct incentive to restrict the use of a product, but insurance
                coverage, removes the consumer’s budget constraint when he or she decides to
                consume health care.
         7. Employer-financed health insurance constitutes a “tax subsidy” because the health
            benefits are exempt from both federal income tax and payroll (social security) taxation.
         8. Figure 36-3a gives graphic portrayal of a competitive health care market (on the demand
            side) that might exist if all consumers were uninsured. Allocative efficiency occurs only
            when we pay in full for a product. In Figure 36-3b we see the effect of health insurance
            paying half the price of health care, so the consumer’s bill for the service is the same as
            half price. Therefore, the quantity consumed will be Qi rather than Qu and there is more
            health care consumed than would be justified by the total cost of this amount of care to
            society. Figure 36-3b illustrates this “welfare loss” be the area abc.
         9. The “equity-efficiency” tradeoff is illustrated here. The dilemma is that if we provide
            social insurance that is believed equitable, then overconsumption will occur, which is
            inefficient. Efficiency may be achieved when less insurance is provided, but this may be
     C. Supply factors also cause rising costs.
         1. Some believe that the supply of physicians has been restricted artificially, but the
            evidence for this argument is not strong, since the number of physicians per 100,000
            people has increased over the years. But the increase in the supply of physicians has not
            kept up with the increase in demand for services provided.
         2. Physicians’ incomes are high in part because of the high costs incurred during their
            education. Although doctors have high rates of return on their educational expenses,
            these returns are below those for lawyers and business school graduates.
         3. Productivity growth has been slow in health care because it is labor intensive and there is
            no strong incentive to raise productivity in a fee-for-service system.
         4. Changes in medical technology have often caused rising costs, because private and
            public insurance pays for new technology regardless of costs. Some studies estimate that
            this accounts for as much as one-half of the growth of health care expenditures.
             CONSIDER THIS … What’s Cold, Clammy, and Out of Date?
     D. Relative importance.
         1. Health care costs have escalated because of both demand and supply side factors as
            enumerated above; however some factors are more important than others.
         2. Most experts attribute the relative rise in health care spending to the following:
             a. Advances in medical technology.
             b. The medical ethic of providing the best treatment available.
             c. Private and public health insurance (the presence of third party-payers).
             d. Fee-for-service physician payments.
V.   Reforming the Health Care System
     A. Again, the two goals of health care reform are containing costs and increasing access. There
        are tradeoffs between these two goals.
     B. Achieving universal access is one goal. Three proposals have been considered.

The Economics of Health Care

          1. “Play or pay” is the name given to a proposal in which employers would be required to
             provide a basic health insurance program for their workers and their dependents (play) or
             pay a special payroll tax to provide health insurance for uninsured workers (pay).
              a. This may lower real wages on the one hand.
              b. It may also lead to more job mobility on the other hand.
              c. Some fear it could lead to a rise in unemployment for low-wage workers.
          2. Tax credits or vouchers offer another approach. Tax credits would be given to low-
             income families to purchase health care coverage, or a voucher would be issued to the
          3. National health insurance is the most far-reaching proposal. It is not “socialized”
             medicine, because the government would not provide health care services, only insure
              a. Proponents say it is the simplest and most direct way to provide universal access, it
                 allows patient choice; it reduces administrative costs (administrative costs are 5
                 percent of total health care costs in Canada, while they are currently about 17 percent
                 of health care costs in U.S.); it increases labor mobility, since health insurance is not
                 tied to the job; and it would give government power to contain costs.
              b. Opponents argue that government price ceilings will not contain costs—-doctors
                 would have too many loopholes; that Canada’s system has waiting lists for certain
                 types of procedures and that technology is not as available as in U.S. today; that the
                 Federal government does not contain costs in other areas very successfully; and that
                 health insurance coverage would become a sort of progressive tax benefit program,
                 since low-income groups would pay little and workers in other industries might find
                 themselves with more take-home income if their employers saved with national
      C. Cost containment: One solution is to alter incentives.
          1. Deductibles and co-payments reduce the overconsumption problem, since the insured
             have higher out-of-pocket costs. Administrative costs have been reduced by eliminating
             small claims.
          2. Managed-care organizations are those in which medical services are controlled or
             coordinated by insurance companies or health care organizations in order to reduce
             health care expenditures.
                  a. In 2001, about 65 percent of U.S. workers received health care through managed-
                     care arrangements.
                  b. Preferred provider organizations (PPOs) give breaks to insurance companies,
                     which rewards the insured for using members of PPO with smaller co-payment
                  c. Health maintenance organizations (HMOs) offer prepaid health plans, which
                     give incentives to the organization to hold costs down, and encourage preventive
                  d. With both PPOs and HMOs, medical services and spending by physicians and
                     hospitals are monitored.
                  e. The disadvantages of managed care from the patient’s perspective is the focus on
                     reducing costs by denying expensive but effective treatment. A “patients’ bill of

                                                                The Economics of Health Care

                 rights” is still being negotiated between the Senate and House of
   3. Medicare reimburses hospitals based on categories of procedures that characterize a
      patient’s condition rather than on what the physician or hospital say is needed regarding
      length and type of hospital care. This is known as diagnosis-related-group (DRG)
D. Recent laws and proposals.
   1. Although Congress has rejected major reforms, it has made some modest changes and is
      discussing others.
       a. The Health Insurance and Portability Act of 1996 ensures that workers with a group
          health plan can continue to buy health insurance when they change jobs or become
          self-employed and prohibits group insurance plans from dropping coverage of a sick
          employee or of a business that has a sick employee.
       b. Medical savings accounts were introduced in 1996 on a trial basis. These tax
          deductible accounts can be used for routine medical expenses and include a
          catastrophic health insurance plan for large medical expenses. Critics contend that
          the accounts create an adverse selection problem by pulling the healthiest and
          wealthiest away from the general insurance market.
       c. A “patients’ bill of rights” was passed in 2000 to regulate HMOs and protect patients
          by guaranteeing access to emergency and specialty care, provide quick review of
          denied medical procedures, and allow families to sue HMOs for actions leading to
          injury or death. However, the U.S. Senate and House of Representatives passed
          different versions of the bill, and as of 2003 still had not negotiated a final version.
       d. Limits on malpractice awards will reduce premiums on malpractice insurance and
          reduce the number of unnecessary tests that doctors perform out of fear of being sued
          for missing a diagnosis. Opponents argue that the threat of large “pain and
          suffering” awards deter medical malpractice.
       e. Prescription drugs are not currently (2003) covered by Medicare, but the coverage
          has growing Congressional support. There are several reasons for this increased
            i.   Prescription drugs are becoming a larger portion of health care spending
                 particularly for the elderly.
            ii. Politicians are aware of the popularity of a prescription-drug benefit among the
                Americans on Medicare.
            iii. Despite this support, there are concerns over the impact on the federal budget
                 and on whether the coverage should extend to all Medicare recipients, or only
                 those of low income.
       f.   Medicare reform was proposed by the Bush administration in 2003. It would provide
            options for different levels of care. One could opt for a basic managed-care plan
            with prescription drug coverage, or pay supplemental premiums for more extensive
            (and more expensive) coverage.

The Economics of Health Care

VI.    LAST WORD: A Market for Human Organs?
       A. Advances in medical technology make it possible for surgeons to replace some human body
          parts with donated “used parts.” But not everyone who needs a transplant can get one. In
          2003, there were 81,000 Americans on the waiting list. It is estimated that there are 4000
          deaths per year in the U.S. because not enough organs are available.
       B. Why shortages?
           1. No market exists for human organs.
           2. The demand curve for human organs would resemble others in that a greater quantity
              would be demanded at low prices than at higher prices.
           3. Donated organs that are rationed by a waiting list have a zero price. The existing supply
              is perfectly inelastic and is the fixed quantity offered by willing donors.
           4. There is a shortage of human organs because at a zero price the quantity demanded
              exceeds the quantity supplied.
       C. Using a market.
           1. A market for human organs would increase the incentive to donate organs. The higher
              the expected price of an organ, the greater would be the number of people willing to have
              their organs sold at death.
           2. The shortage of organs would be eliminated, and the number of organs available for
              transplanting would rise.
       D. Objections.
           1. The first is a moral objection that turning human organs into commodities
              commercializes human beings and diminishes the special nature of human life.
           2. An analytical critique based on the elasticity of supply, suggests that the likely increase
              in the actual number of usable organs for transplants would not be great.
           3. A health-cost concern suggests that a market for body organs would greatly increase the
              cost of health care.
       E. Prohibitions on a human organ market have given rise to a worldwide, $1 billion-per-year
          illegal market. There is concern that those willing to participate in an illegal market such as
          this may also be willing to take extreme measures to solicit organs from unwilling donors.

36-1   Why would increased spending on, say, household appliances or television sets in a particular
       economy be regarded as economically desirable? Why, then, is there so much concern about
       rising expenditures as a percentage of the GDP on health care?
       Increasing expenditures on goods such as household appliances or television sets is regarded as
       desirable because production is expanding under relatively competitive market conditions. Thus,
       not only are output and employment expanding, but presumably these are happening because of
       allocative efficiency. Consumers are choosing to buy appliances or televisions because they are
       willing to pay the price for these goods.
       There is concern about the same rising expenditures in the health care industry because of the
       unique factors that characterize the market for health care services. On the demand side, there is
       imperfect competition in that buyers do not have good information about the services needed or
       the fees that will be charged for the services; doctors control much of this information and, in

                                                                         The Economics of Health Care

       fact, order the services for the consumer in most cases. Third-party insurance companies pay the
       direct costs of most health care on a fee-for-service basis, and therefore the consumer pays less
       than the full price at the time of consumption, leading to overconsumption; overconsumption by
       the insured may also be encouraged by the “moral hazard” problem. On the supply side,
       technology is encouraged without much regard for its cost by insurance providers; doctors also
       control much of the provision of health care in an imperfectly competitive supply structure, since
       they really don’t compete on the basis of price. In other words, many of the unique factors of the
       health care market lead economists to believe that overconsumption is occurring and that society
       is losing because resources are not being allocated efficiently in a way that maximizes society’s
36-2   (Key Question) What are the “twin problems” of the health care industry? How are they related?
       The “twin problems” are rising prices for all and limited access (lack of insurance) for about 16
       percent of the population (41 million). The problems are related since rising costs make
       insurance unaffordable for many individuals and families, and make it difficult for some
       businesses to insure their workers.
36-3   Briefly describe the main features of Medicare and Medicaid, indicating how each is financed.
       Medicare is a nationwide Federal health care program available to social security beneficiaries
       and the disabled. It consists of a hospital insurance program and certain other coverage for post-
       hospital care. It also includes a subsidized medical insurance portion ($58.70 per month in 2003)
       for physician services, lab tests, and other outpatient services. The hospital portion is covered
       through payroll taxes, the same as social security. The medical portion is covered as stated, with
       about three-fourths of the cost being covered by the government.
       Medicaid provides payment for medical benefits to certain low-income people, including the
       elderly, blind, disabled, children, and adults with dependent children who qualify. Nevertheless,
       it covers less than half of those in poverty.
36-4   What are the implications of rapidly rising health care costs for (a) the growth of real wage rates,
       and (b) government budgets? Explain.
       The real total compensation package, wages plus benefits, can only rise as fast as productivity
       does. If health insurance benefits rise more rapidly than productivity, then the real wage
       component of the compensation package is squeezed and it must fall. Workers feel the burden of
       rising health care costs as their take-home wages fall.
       Government budgets are also stretched by rising health care costs, because social security
       recipients qualify for federally financed Medicare benefits, which grow as a result of higher
       health care costs and a greater proportion of the population qualifying for these benefits. All
       levels of government are affected by Medicaid payments, which are financed by a combination
       of state and federal funds. Finally, local governments may also be affected through their support
       of public hospital and other health care facilities, because the uninsured and underinsured need to
       have their health care costs subsidized.
36-5   Who are the main groups without health insurance?
       One group of uninsured is the working poor, who make too much to qualify for Medicaid but not
       enough to afford health insurance. Both they and their employers find it difficult to support this
       cost for minimum-wage and other low-income workers. Another group includes part-time
       workers and those who work for small firms, or who are self-employed in small businesses or on
       farms. Those who believe they are healthy and can avoid accidents, such as young adults, may
       refuse to spend money on insurance, and on the opposite extreme, the chronically ill, who are
       unable to get insurance coverage at all or at any reasonable price, are often without insurance.

The Economics of Health Care

36-6   List the special characteristics of the U.S. health care market, and specify how each affects health
       care problems.
       The health care market has many characteristics that differentiate it from a perfectly competitive
       market. (1) There are ethical questions connected with health care services that don’t arise when
       people are unable to afford other types of goods and services—in general, society regards access
       to basic health care as a right. (2) Buyers of health care typically have little information about
       the services they need and should acquire, creating the unusual situation in which the doctor
       (supplier) orders the services for the patient (consumer). (3) There are significant spillover or
       external benefits connected with health care, suggesting that society should be willing to pay
       more than the amount coming from the private sector alone. (4) Third-party payments are
       common because the patient (consumer) has prepaid for insurance benefits, and about three-
       fourths of all health care expenses are paid in this way. Consumers directly pay lower “out-of-
       pocket” expenses than if they were not insured, which causes them to overconsume.
36-7   (Key Question) What are the estimated income and price elasticities of demand for health care?
       How does each relate to rising health care costs?
       Income elasticity is 1.0, suggesting that health care spending will rise proportionately with
       income. Some studies indicate that it might be 1.5 in the U.S. Price elasticity is only 0.2,
       meaning higher prices for health care services will increase total health care spending.
36-8   Briefly discuss the demand and supply factors that contribute to rising health costs. Specify how
       (a) asymmetric information, (b) fee-for-service payments, (c) defensive medicine, and (d)
       medical ethics, might cause health care costs to rise.
       (a) Asymmetric information refers to the fact that consumers of health care often have very little
           understanding of or access to the information about the health care services that they need.
           Therefore, they must depend on health care professionals to order the services for them.
           This creates the unusual market situation in which producers have the power to create
           demand for what they produce. Even when patients understand and do create the demand, it
           is difficult for them to find price information about health care services. Obviously this
           situation is not a competitive one on the production side, and consequently there is less
           pressure to keep prices low, as would be the case in a competitive industry.
       (b) Fee-for-service payments can contribute to rising health care costs by making it possible for
           providers to increase their incomes by simply ordering more services for the patient. If an
           attempt were made to legally control prices, for example, the provider could simply require
           the patient to purchase more tests, more exams, etc. The administrative costs of billing on a
           fee-for-service basis are also higher than would be the case if there were other types of
           reimbursement for services.
       (c) Defensive medicine refers to the practice that physicians follow to avoid malpractice
           charges. To defend against such concerns, they may order more tests and procedures than
           would be warranted medically or economically.
       (d) Medical ethics, which require the “best practice” techniques, may result in the use of costly
           medical practices with only marginal benefits. Also, the values that promote the support of a
           human life as long as possible, regardless of the cost or condition of life, add to the cost of
           health care.
36-9   “Health care expenditures have been rising principally because of the technological
       transformation of medical care.” Do you agree? Explain.
       Significant advances in medical technology have occurred and have been encouraged by the
       willingness of public and private insurance to pay for new treatments without regard to cost.
       There appears to be an interplay among the availability of new medical technology, increases in

                                                                        The Economics of Health Care

       health care costs, increases the demand for health insurance, and finally increases in the demand
       for the new services. This process is continuous. One illustration of this occurred when
       Medicare programs agreed to pay for magnetic resonance imaging (MRI) scans in 1985; the sales
       of such scanners then rose dramatically.
       Many experts agree that as much as one-half of the increase in health care expenditures is the
       result of advances in medical technology.
36-10 (Key Question) Using the concepts in Chapter 21’s discussion of consumer behavior, explain
      how health care insurance results in an overallocation of resources to the health care industry.
      Use a demand and supply diagram to specify the resulting efficiency loss.
       Health care insurance removes or greatly lessens a person’s budget restraint at the time health
       care is purchased, raising health care utility per dollar spent and causing an overconsumption of
       health care. In Figure 36-3b, insurance reduces the price of health care at the time of purchase
       from Pu to Pi, increasing the quantity consumed from Qu to Qi. At Qi the marginal cost of
       health care is represented by point b and exceeds the marginal benefit represented by c,
       indicating an overallocation of resources. The efficiency loss is area cab.
36-11 How is the moral hazard problem relevant to the health care market?
       The moral hazard problem is relevant to the health care market in two basic ways. First, the
       insured individual may neglect preventive health care, knowing that the costs of illness and/or
       injury are covered. Second, when health care is needed, the insured may overconsume, because
       the out-of-pocket expense for any single service is subsidized by the insurance. Providers may
       also be encouraged to order more tests or treatments than are really necessary when the patient is
       not having to bear the entire cost directly.
36-12 What is the rationale for exempting a firm’s contribution to its workers’ health insurance from
      taxation as worker income? What is the impact of this exemption on allocative efficiency in the
      health care industry?
       The underlying rationale is that spillover benefits exist from a healthy, productive workforce.
       Therefore, it is appropriate to make health care more widely available to workers and their
       families. The impact of the exemption is to make private health care insurance more accessible
       to more people, but it also contributes to the overconsumption problem. Workers in the 28
       percent marginal tax bracket can essentially receive $1.00 worth of insurance for a contribution
       of $.72, which is the after-tax value of that $1.00 in income spent on health insurance. The tax
       subsidy costs the Federal government an estimated $65 billion in forgone revenue and boosts
       private health insurance spending by about one-third. Health care spending may be 10-20
       percent higher than it would be without the tax break.
36-13 Comment on or explain.
       a. “Providing health insurance to achieve equity goals creates a tradeoff with the efficient
          allocation of resources to the health care industry.”
       b. “Improved health habits are desirable, but would not necessarily reduce health care costs.
          For example, the deaths of many smokers are from sudden and lethal heart attacks and are
          therefore medically inexpensive.”
       c. “If government were to require employer-sponsored health insurance for all workers, the
          likely result would be an increase in the unemployment of low-wage workers.”
       (a) If equity means that society has a right to decent health care and universal access is a goal,
           then there will be a tradeoff with the efficient allocation of resources. Under every universal
           access proposal, there is some incentive toward overconsumption of health care resources,
           since by definition of universal access, some people are being provided with access to health

The Economics of Health Care

            care they would otherwise not care to purchase. By providing universal access, all who have
            coverage find health care available at a lower “out-of-pocket” price than would be the case if
            there were no insurance and health care prices were determined on the private market. Thus,
            the quantity demanded will be greater than that justified by the cost of providing the services.
        (b) This statement is true only for those few who may die from sudden, lethal heart attacks.
            Poor habits, such as smoking, lead to increased health care costs for the majority who do
            follow healthy lifestyles. Long-term health care problems, which lead to absenteeism and
            lower productivity in the work force, spells of hospitalization from related illnesses, and
            heart problems that do not result in sudden death, may occur. In considering smoking
            specifically, there is also the potential for causing damage to the health of others through
            secondhand smoke in the air.
        (c) This statement is based on the view that many low-wage workers have low productivity, and
            their employers are paying them according to the theory of marginal revenue productivity—
            in other words, the low wage is equivalent to the value each contributes to the employer’s
            output. To require health insurance coverage, is, in effect, raising the cost of each worker
            and the employer could not afford this without some increase in the worker’s marginal
            revenue product. While the statement seems true on the surface, if every employer faced the
            same requirement, it may have the same result as minimum wage laws, and that is that only a
            very small increase in unemployment results.
36-14 Briefly describe (a) “play or pay”; (b) tax credits and vouchers; and (c) national health insurance
      as means of increasing access to health care. What are the major criticisms of national health
        (a) “Play or pay” refers to the proposal whereby employers must either provide health insurance
            to their employees (play) or pay a tax into a public insurance fund for those employees not
            insured (pay).
        (b) The tax credit or voucher proposal is to give access to those who cannot now afford private
            insurance. Low-income households would be given a credit to use for health insurance, thus
            reducing their tax by the cost of the insurance. The poorest households, for whom a credit
            would not apply, would be given vouchers to use in purchasing private health insurance in
            much the same way as food stamps are used to purchase food.
        (c) National health insurance would provide a basic package of health care to every citizen at no
            direct charge or at a low-cost sharing level. It would be financed by tax revenues. Private
            insurers could continue to offer health coverage for procedures not covered by the national
            health insurance package.
        Critics of national health insurance charge that government-controlled fees are not likely to
        control costs, since providers can circumvent the low fees by ordering more procedures, more
        frequent visits, and so forth. They also point to excess demand for health care in countries where
        national health insurance exists. In Canada, the government’s efforts to control costs have
        resulted in a shortage of technology and other services available to meet the demand. Critics
        argue that the Federal government does not have a good track record in cost containment.
        Finally, they fear some of the redistributional effects of national health insurance, which would,
        by and large, result in a more progressive tax-subsidy structure, as low-income people would
        receive more benefits and high-income groups would pay more into the system than the value of
        the benefits they receive.
36-15 What are (a) preferred provider organizations and (b) health maintenance organizations? Explain
      how each is designed to alleviate the overconsumption of health care.

                                                                        The Economics of Health Care

       (a) Preferred provider organizations (PPOs) are collective agreements among hospitals, doctors,
           and insurance companies in which the providers (hospitals and doctors) agree in advance to
           provide discounts on their services in exchange for receiving the business of those insured by
           the company in question. Policy holders are given a list of those cooperating hospitals,
           clinics, and physicians and will receive greater reimbursement by patronizing those members
           of the PPO. Usually, the patient has a choice to receive care elsewhere, but at a lower
           insurance reimbursement level.
       (b) Health maintenance organizations (HMOs) are organizations which contract with employers,
           insurance companies, labor unions, or other groups to provide medical care for their
           members. HMOs alter the traditional fee-for-service arrangement by providing prepaid
           health plans, which usually cover preventive care as well as sickness and injury.
       PPOs lower costs by the agreement to lower fees in exchange for the contract from the insurance
       company. The use of one organization can also lower administrative costs substantially, as
       uniform medical forms and bills are streamlined. HMOs are considered “managed care”
       systems, because utilization and spending are “managed” or controlled by close monitoring of
       physician and provider behavior to eliminate unneeded tests and treatments, since HMOs operate
       on a fixed budget. The existence of a budget for HMOs, which don’t charge on a fee-for-service
       basis, provides an incentive to economize on services offered to each patient. Furthermore, by
       encouraging patients to receive preventive care, HMOs might also reduce the higher cost of the
       hospitalization of ill patients.
36-16 Do you think prescription drugs should be covered under Medicare? Are you willing to pay a
      higher social security/Medicare tax to pay for this added benefit? Do you think the prescription-
      drug benefit should go to everyone covered by Medicare, including those who can easily afford
      to pay for the prescription drugs out of pocket?
       Prescription drugs are becoming a more significant part of health care costs and are claiming a
       larger share of the income of older Americans. Some older Americans must sacrifice necessities
       to pay for prescription drugs or choose to do without the drugs even when they are required to
       maintain health. Personally, I am willing to pay a higher Medicare tax. As with social security
       and Medicare, the benefit should be considered a social insurance program and be available to all
       who are Medicare eligible.
36-17 Which of the following groups do you think would favor limits on “pain and suffering” awards in
      suits against HMOs and doctors: health insurance companies, advocacy groups for patients’
      rights, physicians, trial lawyers? Explain.
       Health insurance companies and physicians would favor such limits. Large “pain and suffering”
       awards increase costs and reduce profits for these groups. Trial lawyers would definitely oppose
       limits as they often are paid on contingency, receiving a percentage of the award as
       compensation. Patients’ rights groups would tend to oppose limits, as they would keep victims
       of malpractice from receiving what they believe they are entitled to, as well as reducing the cost
       of committing malpractice (thus increasing the likelihood of it occurring). At the same time
       patients’ rights groups may also have an interest in keeping costs down to make health care more


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